Buying stock in a company can be risky. This is why most investors analyze the potential short-term and long-term value of new shares of stock before deciding whether to invest in them. The value of stock depends on the company's growth and the expected rate of return, which investors can determine by examining similar stocks.
Investors are interested in the return they can expect on their investment. They can figure out their expected return if they know the stock's current value and the value of dividends paid out. Investors can also determine the price of a particular stock by using the formula. Add the dividends paid out and the expected price of the stock, then divide these by 1 minus the expected return.
The stock price and expected return both examine the way the investment is expected to grow over a short period of time, such as one year. The stock's current price doesn't really tell investors what they can expect to earn over the course of a lifetime. The long-term value of the investment is based more on the value of dividends than on the stock's current price.
Discounted Cash Flow
Because it is difficult to estimate a stock's long-term value based on its current price, investors often use the discounted cash flow formula to determine the stock's total value. Investors can estimate the dividends over a period of time by looking at stocks that have a similar risk level. You can divide their estimation by a calculation based on the length of time and the expected rate of return.
Formulas to determine the value of new shares of stock assume a constant, or near-constant growth rate. This rate might not be realistic if a company is new, or has just entered a growth phase. In addition, some stock is a higher risk investment than other investments. It's important to only compare stocks with established stocks of similar risk when estimating the stock's cash flow rate and value.